Locke Lord QuickStudy: NYAG Flexes Regulatory Muscle—Injunction Against Virtual Currency Exchange Bitfinex

Bitfinex—one of the largest cryptocurrency exchange platforms in the world—is under ‎investigation by the New York Attorney General (the “NYAG”) for allegedly violating New ‎York securities law under the Martin Act.‎

On April 24, 2019, the NYAG obtained an ex parte order¹ ‎precluding Bitfinex, and its ‎affiliated stablecoin firm Tether, from engaging in fraudulent conduct that violate New York’s ‎General Business Law (“GBL”).‎² ‎The order also requires Bitfinex and Tether to turn-over ‎documents related to NYAG’s investigation into Bitfinex’s allegedly fraudulent acts, such as ‎commingling client and corporate funds, misleading clients about Tether’s cash reserves, and ‎failing to disclose $850 million in losses. On May 13, 2019, both parties filed individual ‎proposals outlining their respective positions about the full scope of the continuing preliminary ‎injunction.‎³ However, the court has yet to rule on these proposals and has failed to specify when ‎it plans to lift the injunction—creating more questions than answers.‎

NYAG Allegations

The ex parte order stems from an investigation that the NYAG commenced in 2018 to ‎determine whether Bitfinex and Tether were in compliance with New York securities and anti-‎fraud regulations. In its petition, the NYAG alleges that Bitfinex, along with its various ‎subsidiary companies, engaged in numerous activities that put U.S.-based investors at risk.‎⁴

First, “at no point known to NYAG has Bitfinex or Tether disclosed to clients that they ‎have used third party ‘payment processors’ to handle client withdrawal, nor have they disclosed ‎who those ‘payment process’ are.”‎⁵ In fact, the NYAG explained that Bitfinex and Tether have a ‎history of troubled banking relationships, and struggled to secure a stable banking partnerships ‎with credible institutions. For example, within a two year period, Wells Fargo dropped Bitfinex ‎as a client and Noble Bank International ceased operations earlier this year.⁶ ‎

Second, the NYAG alleges that Bitfinex comingled over $1 billion in client and corporate ‎funds with a Panamanian entity called Crypto Capital Fund Corp. (“Crypto Capital”).⁷‎ ‎ ‎According to the NYAG, neither Bitfinex nor Tether ever entered into a written agreement with ‎Crypto Capital. By failing to enter into a contractual relationship with its payment processor, ‎Bitfinex and Tether allegedly put its client funds at risk.⁸‎

Third, Crypto Capital failed to process customer withdraw requests and/or refused to ‎return funds to Bitfinex. “According to documents provided to NYAG by [Bitfinex], and based ‎on statements made by counsel for [Bitfinex] to NYAG attorneys, an individual at Crypto ‎Capital told the senior Bitfinex executive the reasons that funds totaling $850 million could not ‎be return to Bitfinex was because the funds were seized by governmental authorities in Portugal, ‎Poland, and the United States.”^9‎ ‎To make up for this loss of funds, the NYAG alleges that ‎Bitfinex and Tether engaged in undisclosed, conflicted transactions to cover Bitfinex’s losses by ‎transferring money out of Tether’s reserve funds. Due to this alleged cover-up, NYAG provides ‎that Bitfinex misled its clients (including both clients of the Bitfinex trading platform and ‎holders of tether) about the line of credit transaction to cover Bitfinex’s $850 million loss.

In its effort to obtain further information, NYAG’s ex parte petition¹⁰‎ sought a wide ‎range of documents relating the allegations described above, including the following:‎

• All documents concerning Bitfinex users, accounts, clients, or customers that reside or are ‎believed to reside, do business, or are believed to do business, in New York.‎
• All documents and communications regarding any transaction, of whatever nature, to ‎loan, extend credit, encumber, pledge, or make any other claim, of any variety or ‎description, on the U.S. dollar reserves underlying tethers to Bitfinex or any other entity.‎
• All documents and communications regarding any transaction, of whatever nature, to ‎purchase, borrow, disperse, or loan tethers to or from third parties, including between ‎Tether and Bitfinex, wherever located.‎

Bitfinex’s Response

In response to the NYAG’s allegations, Bitfinex issued a press release on its website, ‎providing that “[t]he New York Attorney General’s court filings were written in bad faith and ‎are riddled with false assertions, including as to a purported $850 million ‘loss’ at Crypto ‎Capital.”¹¹‎ ‎The press release goes on to provide that “Bitfinex and Tether will vigorously ‎challenge this, and any and all other actions, by the New York Attorney General’s office.”¹²‎

On April 30, 2019, Bitfinex and Tether moved to vacate the ex parte order on three grounds:¹³‎

1. Bitfinex and Tether argued that, as a preliminary matter, the NYAG failed to articulate ‎that tethers qualify as securities or commodities covered by the Martin Act, which is a ‎threshold to determine whether the NYAG has jurisdiction.¹⁴‎
2. They claimed that the NYAG failed to use the correct preliminary injunction standard ‎that is generally used for Martin Act cases.
3. Bitfinex and Tether further argued that a preliminary injunction is not the proper remedy ‎in this case because it is “hugely disruptive” in light of the fact that it freezes over $2 ‎billion of Tether’s reserves.

Court Order to Limit Scope of Document Request

According to media sources, on May 6, 2019, the court ordered Bitfinex to turn over ‎documents relating to the alleged $850 million tether-backed loan Bitfinex secured to cover up ‎losses—with one caveat—the parties provide either joint or individual proposals outlining the ‎scope of the injunction.‎¹⁵‎ While this court order has not been made public, it has been reported ‎that Judge Cohen characterized NYAG’s document request as both “amorphous and endless.”¹⁶‎‎ ‎The court further addressed the issue of whether the NYAG has jurisdiction to bring claims ‎against Bitfinex since the Martin Act only applies to “securities and commodities.”¹⁷‎‎ The court ‎explained that while the issue of whether Bitfinex is subject to the Martin Act is a threshold ‎question, “[a]s a law enforcement agency it doesn’t seem really out of bounds to just probe ‎whether an otherwise unregulated business involves securities which are subject to the Martin ‎Act.”¹⁸‎‎ On May 13, 2019 both parties filed individual proposals¹⁹‎ explaining their positions about ‎the scope of the injunction, including the length of time the NYAG needs to conduct their ‎investigation and the scope of discovery. The court has not ruled on these proposals and has ‎failed to provide a clear date for when it plans to lift the preliminary injunction.‎

Conclusion

The NYAG investigation raises concerns about Bitfinex and its ability to operate a virtual ‎currency exchange platform that complies with New York regulations. The investigation also ‎calls into question Tether’s stablecoin, touted as being pegged to the U.S. dollar. While there are ‎many questions left unanswered, New York regulators continue to flex their muscle in the ‎cryptocurrency arena.‎

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_{‎1. See Ex Parte Order Pursuant to General Business ‎‎§ 354, Supreme Court of the State of New York, County of New ‎York, Index No.: ‎‎450545/2019.‎}

_{2. New York's Martin Act, New York General Business Law § 352 et seq.‎}

_{3. OAG’s Correspondence to Judge Joel M. Cohen, In the Matter of iFinex, Inc., et al., Index No. 450545/2019 and ‎Respondent’s Letter Regarding Proposed Form of Order on Motion to Vacate or Modify, In re Letitia James v. ‎iFinex Inc., et al., Index No.: 450545/2019 (N.Y. Sup. Ct.) Proposed Order on Motion to Vacate or Modify (Motion ‎Seq. 002).‎}

_{4. See James v. iFINEX INC. et al., Affirmation of Brian M. Whitehurst In Support of NYAG’s Ex Parte Application ‎for an Order Pursuant to General Business Law § 354, Supreme Court of the State of New York, County of New ‎York, Index No.: 450545/2019.‎}

_{5. Id.‎}

_{6. Id.‎}

_{7. Id.‎}

_{8. Id.‎}

_{9. Id.‎}

_{10. Id.‎}

_{11. See Announcements: Bitfinex Responds to New York Attorney General’s Actions, Bitfinex (April 26, 2019).‎}

_{12. Id.‎}

_{13. See James v. iFINEX INC. et al., Respondents’ Reply Memorandum of Law in Further Support of their Motion, ‎by ‎Order to Show Cause, to Vacate, or Modify the April 24, 2019, Ex Parte Order, Supreme Court of the State of ‎New ‎York, County of New York, Index No.: 450545/2019.‎}

_{14. Under the Martin Act, the NYAG’s office can regulate securities and commodities, or the venues where securities ‎and commodities are traded.‎}

_{15. See Nikhilesh De, Judge Asks NYAG to Narrow Scope of “Amorphous” Bitfinex Document Request, Coindesk ‎‎(May 6, ‎‎2019).‎}

_{16. Id.‎}

_{17. Id.‎}

_{18. Id.‎}

_{19. For a more comprehensive discussion about the proposed scope of discovery, please refer to OAG’s ‎Correspondence to Judge Joel M. Cohen, In the Matter of iFinex, Inc., et al., Index No. 450545/2019 and ‎Respondent’s Letter Regarding Proposed Form of Order on Motion to Vacate or Modify, In re Letitia James v. ‎iFinex Inc., et al., Index No.: 450545/2019 (N.Y. Sup. Ct.) Proposed Order on Motion to Vacate or Modify (Motion ‎Seq. 002).‎}